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Figure 7: A Financial Stress Index for China’s Banking Sector BankFSI
Figure 8: Financial Stress Index without Risk Spread for China’s Banking Sector
4.1.2 Stock Markets
The systemic stress and risks in stock markets are measured by the volatility of the stock index. We estimated the volatility using a GARCH 1, 1 model.
Following Bollerslev and Chou 1992, a simple GARCH 1, 1 model is defined as
, 0,1
t t
t
V C
X IID
θ ε ε
′ =
+ +
2
2 2
2 1
1
.
t t
t
c
σ αε
βσ
− −
=+ +
3
-4 -2
2 4
6 8
94 96
98 00
02 04
06 08
10 12
-3 -2
-1 1
2 3
4
94 96
98 00
02 04
06 08
10 12
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where
t
V
denotes the month-to-month change in the Shanghai stock market index in our study, and the standard deviation
t
σ
predicts the risk in the stock market. The FSI for China’s stock markets SMFSI constructed by GARCH 1, 1 is
presented in Figure 9. The figure indicates that China’s stock markets are very volatile over the examined period.
Figure 9: China’s Stock Market FSI SMFSI
4.1.3 Foreign Exchange Market
The stress in China’s foreign markets is also measured by the volatility. Following Balakrishan et al. 2009, the FSI for foreign exchange markets EMFSI is
defined as
t t
t t
t e
t RES
e RES
e RES
EMFSI
µ µ
σ σ
∆ ∆
∆ ∆
∆ − ∆
− =
−
4 where
t
e ∆
denotes the month-to-month change in real exchange rate, and
t
RES ∆
is the month-to-month change in foreign reserves;
,
x x
µ σ
represent the average values and standard variances of the respective variables, respectively.
Figure 10 depicts the EMFSI for China’s foreign exchange markets. EMFSI captures several episodes of exchange rate volatilities in China’s foreign exchange
market including an abrupt appreciation in later 1994 and then deep depreciation in 1995 by China’s government to enhance the exports, the announcement on a
-6 -5
-4 -3
-2 -1
1 2
3
94 96
98 00
02 04
06 08
10 12
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floating exchange system by China’s government in 2005, the global financial crisis of 2008, and the Euro area sovereign debt crisis, all these produced dramatic
fluctuations in EMFSI, shown by Figure 10.
Figure 10: FSI for China’s Foreign Exchange Market EMFSI
4.1.4 Debt Market
Two indicators are employed to measure the stress in China’s debt markets following the conventional literature. The first one is the bond yield spread, which
is a useful predictor of recession;
5
the second is the sovereign debt spread, showing international liquidity.
Bond yield spread The spread between the long-term bond yield and the short-term bond yield is used
as a possible predictor for the economic recession and as a proxy for the uncertainty in the government bond markets.
Bond yield spreadt =C 10 TB
t
– C 1TB
t
5 where C10TB represents the 10-year government bond yields, and C1TB denotes
1-year government bond yield. We do not use 3-month Treasury bill yields because the period of data yields rates available for the 3-month bond in China’s
_________________________
5 See, for example, Oet et al. 2011, Estrella and Mishikin 1995, Haubrich and Biano 2011.
-6 -4
-2 2
4
94 96
98 00
02 04
06 08
10 12
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short-term bond market is very short. The 1-year government bond is used as it is most popular and has a very long issuance history in China.
Sovereign debt spread This term is defined by China’s 10-year government bond yields minus the US 10-
year government bond yields:
Sovereign debt spreadt = C 10 TB
t
– US 10 TB
t
6 Combining the bond yield spread and the sovereign debt spread, we obtain an
FSI for China’s debt markets DMFSI by equal-variance weighting in Figure 11. In this figure, we find that the financial stress increased in China’s debt market
after 2009 due to the contagion effects of the international financial crisis.
Figure 11: FSI for China’s Debt Markets DMFSI
-4 -3
-2 -1
1 2
3 4
94 96
98 00
02 04
06 08
10 12
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4.1.5 Overall FSI for China’s Financial System CNFSI
